In the financial industry, ‘foreign exchange’ or FX markets refer to transactions or deals where one country's currency is traded for another (based upon a current or projected exchange rate). As can be imagined, worldwide, this trading market is an ever growing market where accuracy and projections are keys to success. Today, FX trading is a lucrative market for large banks, reserve or central banks, currency traders, corporations, governments, and other institutions. For instance, on average, it is believed that worldwide FX trades exceed two trillion dollars per day, and continues to grow.
With this lucrative market comes a great amount of risk for the traders. For example, economic conditions and political stability are at least two factors that effect trading. In other words, knowledge is key to trading decisions as well as to project when to make the decisions. Economic policies (e.g., fiscal policies, monetary policies, interest rates) are most often propagated by governments and, as a result, effect economic conditions and thereafter trading values.
Similarly, political conditions can affect currency markets around the globe. For instance, instability within a government can perpetuate a negative impact on nation's economy. Likewise, a perceived fiscally responsible government can project a positive impact on the nation's economy. Both of these situations can contribute to FX trade values respectively.
In the FX markets, there are several types of financial instruments commonly used in trading. These transactions include ‘forward’, ‘future’, ‘spot’ and ‘option’ transactions. Each of these types of transactions shares unique risks and rewards. As such, managing an FX portfolio can be extremely lucrative or, alternative devastating to the financial viability of an entity.
A ‘forward’ transaction can assist in managing risk associated with FX markets. More particularly, because funds do not transfer until a future date, risk can most often be managed more easily. Here, the parties to the transaction (e.g., buyer and seller) reach agreement on an exchange rate which is consummated on a date in the future. With regard to ‘forward’ transactions, the transaction is completed on the agreed upon date, regardless of the market rates on that date. One common type of ‘forward’ transaction is a ‘currency swap’, where parties agree to exchange currencies for a certain length of time and to the reverse the same at a later date.
In the FX markets, a ‘future’ refers to a ‘forward’ transaction with standard contract sizes and maturity dates. As an example, parties can agree to transfer X dollars next September at an agreed upon exchange rate. Traditionally, ‘futures’ are traded on a specific exchange.
A ‘spot’ transaction is a two-day delivery transaction, as opposed to the aforementioned ‘futures,’ which are usually at least three months. A ‘spot’ trade refers to a direct exchange between two currencies. In other words, ‘spot’ trades involve cash rather than a contract as in other types of financial transactions. As such, the ‘spot market’ is a commodities or securities market where goods (e.g., foreign currency) are sold for cash.
When transferring funds worldwide, today, the industry has developed and standardized upon SWIFT, Society for Worldwide Interbank Financial Telecommunications. Similar to the FED (or the Federal Reserve System) for domestic transactions, SWIFT is a secure financial messaging network that can be used to communicate FX messages securely and reliably between global financial institutions. Additionally, SWIFT is also a vendor of software and services to financial institutions who desire to participate in the FX markets. Essentially, SWIFT provides common standards for financial transactions as well as a shared data processing system and worldwide communications network.
Accordingly, becoming SWIFT-enabled is not an easy or inexpensive task. For at least this reason, many financial institutions rely upon larger and more equipped financial institutions to assume risk, build the necessary infrastructure (e.g., SWIFT network) and assist in FX transactions. Unfortunately, although smaller institutions can participate in the FX market by relying upon larger, more capable institutions, without a common framework, this reliance requires extensive and multiple manual processes which, as can be imagined, add to cost, inefficiencies and frequently, human error.